RSM Resources

Congress created a wide-ranging domestic manufacturers’ deduction(DMD) as part of the American Jobs Creation Act of 2004. However, thelaw’s complexity caused many small and midsized companies to shy awayfrom seeking potential tax benefits.

But the latest regulatoryguidance on the DMD, offered by the U.S. Treasury Department lastsummer, clarified several key elements in the law and providedpotential incentives for early 2006 filers to revisit their returns insearch of added deductions.

Prior to 2007, the manufacturers’deduction allowed companies to take a 3 percent deduction on the lesserof qualified production activities income (QPAI) or overall taxableincome. The deduction was limited to 50 percent of a company’s overallW-2 wages in a given year. In 2007, the DMD increased to 6 percent, andit is scheduled to rise to 9 percent by 2010. The deduction isavailable to qualifying C corporations, S corporations, partnerships,sole proprietorships, estates and trusts.

To calculate QPAI,take gross receipts from qualified domestic production activities(domestic production gross receipts, or DPGR) and subtract the costs ofgoods sold and certain other direct and indirect costs allocable tothose activities.

Industries that may benefit from the DMD include firms that:

• Manufacture, produce, grow or extract tangible personal property in the United States.
• Handlefilm production, provided that at least half of total compensation forproduction costs is for services they perform in the United States.
• Produce domestic electricity, natural gas or water.
• Provide engineering and architectural services in the United States.
• Engagein substantial renovation of real property or infrastructure, such asresidential and commercial buildings, roads, power lines, watersystems, and communications facilities.

Key changes in final regulations

Initialguidance limited the DMD to 50 percent of a company’s total W-2 wages.However, the Tax Increase Prevention and Reconciliation Act of 2005(TIPRA) narrowed the scope of that deduction to include only W-2 wagesthat can be directly allocated to domestic production gross receipts.In short, nonmanufacturing wages are now excluded from the deduction,says Joe Mudd, a managing director in RSM McGladrey’s national taxpractice.

"If a company originally had $100 in W-2 income thatwas deductible, but only 40 percent of those wages can be allocated toDPGR, that means the deduction is now limited to $40 rather than $100,"Mudd says. "This is a very significant change in the amount ofdeduction allowed for many taxpayers."

In another major change,the regulations expanded eligibility guidelines for companies allowedto use a simplified method for calculating the DMD. Originally, the lawrequired businesses with annual gross receipts of more than $25 millionto painstakingly allocate expenses between domestic and foreign-basedincome by following Section 861 of the IRS Code. The simplified methodlet companies allocate costs and other items based on the percentage oftotal receipts qualifying as DPGR. The revised law expands the cap ongross receipts to $100 million, which Mudd says will save many midsizedcompanies considerable time and effort.

"Section 861 ishorrendously complex and can be very expensive for smaller and midsizedfirms to interpret," he says. "Since the average filer for the DMD is abusiness with about $25 million in annual gross receipts, thisexpansion to $100 million will allow roughly another 30 percent ofqualifying U.S. businesses to use the simplified method."

However,with the easier filing requirements, companies may not get every dollarin deductions to which they may be entitled. Mudd says companies with ahigh percentage of qualified production in overseas markets are mostlikely to benefit from a more detailed DMD calculation using theSection 861 criteria.

In the construction industry, one of themost contentious issues regarding the DMD was whether qualifyingbuilders or developers would be forced to include the fast-appreciatingvalue of undeveloped land as part of their DPGR calculations. However,in the final regulations, Treasury officials reinforced a "land safeharbor" provision that caps the land’s value at an estimated annualinflation rate. That delivers two key benefits to constructionbusinesses: It understates the actual rate at which land has gainedvalue and minimizes the amount undeveloped land holdings can be countedagainst domestic production gross receipts.

Consider aconstruction company that bought land a decade ago for $1 million andis ready to build on that property, which has a current market value of$3 million. The final DMD regulations allow the company to exclude thegain attributable to the land, so that same $1 million property mightbe valued at $1.1 million for DMD purposes. The company could take the$1.9 million difference between actual market value and cap value, andallocate it toward the DMD.

The clarifications and changes inthe final regulations provide a great opportunity for companies torevisit the benefits of the DMD. In 2004, the deduction generated only$77 million in tax savings for qualifying firms — a low numberconsidering the wide scope of businesses that potentially qualify. Forthat reason, Mudd says early filers from last year may do well tocarefully review their returns.

"Taxpayers who filed prior toJune 1, 2006, were operating under the proposed rules, which in manyways are not as favorable as the final regulations," he says."Companies have the option to amend their returns, and it’s worth asecond look, because in some cases it could be the difference betweenreceiving a deduction or not getting one at all."